Wage Subsidies

Instructor: Alex Tabarrok, George Mason University

What’s the difference between a wage subsidy and a minimum wage? What is the cost of a wage subsidy to taxpayers? We take a look at the earned income tax credit and

What’s the difference between a wage subsidy and a minimum wage? What is the cost of a wage subsidy to taxpayers? We take a look at the earned income tax credit and how it affects low-skilled workers. We also discuss Nobel Prize-winning economist Edmund Phelps' work on wage subsidies.

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In our final lecture on taxes and subsidies, we're going to take a look at wage subsidies and compare them to the minimum wage.


Suppose that we are especially interested in increasing the number of jobs for low-skilled workers. That is, we think that the value of these jobs exceeds the wage, the value, to consumers. Perhaps because we believe that there's a special duty to reduce poverty, or that an increase in number of low-skilled jobs would reduce welfare payments, or perhaps reduce crime or inequality or increase social cohesion. There may be a variety of reasons. If that's what we're interested in, then Edmund Phelps argues that one of the best means of doing this is through a wage subsidy.


So let's take a look. Well imagine that the market wage starts out here at $10.50, and here's the quantity of labor exchanged at that market wage. Our wage subsidy is given by this wage wedge. Let's call this a $4 wage wedge. As usual, we drive it into the diagram and that will give us the wage received by workers as well as the wage paid by firms. So notice what the wage subsidy does. It reduces the wage to firms so the firms want to hire more workers, and at the same time it increases the wage to workers. And the division is, as usual, is going to be determined by the relative elasticities of demand and supply. For the same reasons that a wage tax probably falls mostly on workers, a wage subsidy will fall mostly on workers as well, though I've drawn it more evenly here.


Now what's the cost of a wage subsidy? Well the wage subsidy could have a big cost to taxpayers, namely the per job cost, the $4 cost, or this could be per hour cost, times the total number of hours. So the cost of the subsidies given by this entire blue area right here.


Now Edmund Phelps argues that the cost would actually be less than this because of savings on crime and welfare payments and other things like that. So it may be worth doing. It's also worthwhile to compare a wage subsidy with a minimum wage.


Now we haven't actually talked about the minimum wage yet and we're going to do so in a future chapter. So consider this bonus material. This maybe material you may want to come back to at a later time. But let's imagine that we have a minimum wage at the same level as would be created by the wage subsidy. In this case a minimum wage of let's say, $12. Key point - there are two key points about the minimum wage. First, it doesn't cost the government anything, which is one reason why taxpayers may like it better than the wage subsidy. It does cost employers. And what we can see is that at this minimum wage, the demand for labor would be much less. The demand for labor would only be Qd.


So a big difference between a wage subsidy and a minimum wage is that the wage subsidy increases the demand for labor. It increases the number of low-skilled jobs. While a minimum wage decreases the demand for labor and decreases the number of low-skilled jobs. That's one reason why economists tend to be more in favor of wage subsidies than they do of minimum wages. We actually have an extensive wage subsidy program in the United States that's very large. It's not talked about as much as the minimum wage. It's called the Earned Income Tax Credit, and a lot of economists, such as Edmund Phelps, Nobel Prize winner, argue that a better way of helping low-skilled workers is to expand the Earned Income Tax Credit, make it available to more workers, and this in fact this would be superior to a minimum wage.


Okay, we'll be talking more about these issues later on. That's enough for today. Thanks.

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